The Art of Italian Bookkeeping (Cont.)

Italy has escaped the EU’s excessive deficit procedure for now. This was made possible because the Italian government curbed the three main electoral promises it had previously made to voters. However, it did so by underestimating the costs of the planned measures.

A perfect escape?

According to the initial draft of the Italian government budget from October 2018, the budget deficit would have remained at 2.4% in 2019. However, after a vivid dispute with the European Commission, a deficit of 2.04% was agreed.

This reduction in the planned deficit was what permitted Italy to avert the EU excessive deficit procedure for the time being.

To achieve that goal, the Italian government curbed the three main electoral promises – citizenship income, abolishment of the pension reform and (for 2020 and 2021) safeguards on the value added tax (VAT).

In particular, there now is a major gap between the agreed (7.1 billion euros) and potentially required (17 billion euros) funds to cover all seven million Italians entitled to the “citizenship income.”

Among other artful moves, the funds for the revocation of the so-called “Fornero” pension reform are also being cut (or “saved,” as that the measure can most probably start only in the second half of the year).

However, they are far below the estimated 13 billion euros needed to dial back the pension reform.

Italy’s budget plan should be, however, treated for what it is – namely, a pie in the sky. This is so for two main reasons. First, the implementing decrees for the planned measures must still be announced in the coming months.

And since these measures are the symbol of the political joint venture between the ruling populist parties, the Lega and Cinque Stelle, it is plausible to expect that the government will push to deliver them sooner than later.

Italy in recession again

Second, Italy has once again entered a recession at the end of 2018, which renders the entire government’s budget planning far more complicated and less predictable.

An additional challenge in keeping the budget in line with the government’s official plan could come from the Italian banking sector. Although the progress in the write-off of non-performing loans (NPLs) is undeniable, the remaining NPL-stock is still substantial (106 billion euros of net exposures at the end of 2018).

Moreover, provisions for impaired loans have been reduced during good times and most probably will not be increased – as they should be – during bad times. Should the recent economic slowdown in Italy persist, both the Italian banking system and the government finances could be negatively hit.

Scenario analysis

Accounting for these uncertainties and based on the available information, we ran three scenarios:

1. “benign,”

2. “government +,”

3. “adverse”

– on the evolution of the Italian government budget over the three-year period of the government projections between 2019 and 2021.

Scenario 1

In the “benign” scenario, we assume that the government delivers on the formal commitments contained in the current budget law, but fails to deliver on its electoral promises.

However, we take the downward revised estimates of real GDP growth and CPI inflation of the European Commission (EC), from early February 2019.

Scenario 2

Under “government +,” we take the growth forecasts of the European Commission from the benign scenario, but assume that the costs for both the citizenship income and the pension reform are underestimated by half the gap between the planed and potentially needed funds (i.e. additional 5.5 billion euros).

We also make the plausible hypothesis that the government would not raise VAT, resulting in 12.5 billion euros less in revenues in each 2020 and 2021.

Scenario 3

In the adverse scenario, the Italian economy would enter a recession in 2019 (with nominal GDP growth of -1.5%, which is half the magnitude observed in 2009) and would turn back to grow moderately afterwards, in line with European Commission forecasts.

Accordingly, following the experience of the past crises, we assume that the expenditure/GDP ratio would rise by three percentage points in each year in the period 2019-2021, compared with the ratio observed in the pre-crisis year.

The assumptions under Scenario 2 and 3 are conservative. Additional expenditures under Scenario 2 are only the minimum, or flagship “adjustments” to bring the government plan more in line with the election promises. Scenario 3, instead, does not include a possible bail-out of the banking sector.

Figure 1 illustrates the three scenarios and compares them with the baseline of the Italian government from the budget law. The mere slowdown in economic growth as currently predicted by the European Commission would not have a significant impact on the path of the deficit ratio, provided that the Italian government sticks to the numbers promised to the Commission.

Enlarge

However, more realistic are the other two scenarios. The main findings are as follows:

1. Should the “government of change” enforce its most important election promises, the deficit ratio would reach 2.38% in 2019, 2.89% in 2020 and 2.53% in 2021.

2. And in case of the assumed economic recession the deficit ratio would rise to 5.28% in 2019, before falling to 3.09% and 2.77% in the following two years.

Conclusion

To sum up, so far Rome has managed to kill three birds with one stone. The government reached a compromise with Brussels on the budget and negotiated a budget deficit which is already above the limit compatible with the fiscal rules of the Stability and Growth Pact.

And it magically did so by including all the promised measures in its budget law, albeit in homeopathic doses. The way of minimal confrontation with Brussels helps Rome to save face ahead of the European Parliament elections in May 2019.

But after those elections, the Italian government could use the favor of the hour and enter the next round of its budget game. Past experiences provide a strong indication for that.